Free Banking and Information Asymmetry

Kam Hon Chu

Journal of Money, Credit and Banking, 1999, vol. 31, issue 4, 748-62

Abstract: A traditional argument against free banking is that it will collapse because of information externalities: it is impossible for depositors to tell whether a high deposit rate offered by a bank is due to its high efficiency or risky lending strategy. This paper shows that in a separating equilibrium a higher-quality bank offers a lower deposit rate and holds a smaller proportion of risky loans than a lower-quality bank to signal its underlying quality. Hence, free banking is not inherently unstable. The empirical results for the Hong Kong banking system during 1964-65 are consistent with the hypothesis of a separating equilibrium.

Date: 1999
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Persistent link: https://EconPapers.repec.org/RePEc:mcb:jmoncb:v:31:y:1999:i:4:p:748-62

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